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Real options signaling games with applications to corporate finance PDF

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Real options signaling games with applications to corporate finance The MIT Faculty has made this article openly available. Please share how this access benefits you. Your story matters. Citation Grenadier, S. R., and A. Malenko. “Real Options Signaling Games with Applications to Corporate Finance.” Review of Financial Studies 24.12 (2011): 3993–4036. Web. As Published http://dx.doi.org/10.1093/rfs/hhr071 Publisher Oxford University Press Version Author's final manuscript Accessed Tue Apr 09 14:37:06 EDT 2019 Citable Link http://hdl.handle.net/1721.1/75378 Terms of Use Creative Commons Attribution-Noncommercial-Share Alike 3.0 Detailed Terms http://creativecommons.org/licenses/by-nc-sa/3.0/ Real Options Signaling Games with Applications to Corporate Finance (cid:3) Steven R. Grenadier Andrey Malenko Stanford University Massachusetts Institute of Technology June 2011 We thank the anonymous referee, Anat Admati, Felipe Aguerrevere, Geert Bekaert, (cid:3) Nina Boyarchenko, Cecilia Bustamante, Nadya Malenko, Ilya Strebulaev, Pietro Veronesi (the editor), Neng Wang, Je⁄rey Zwiebel, seminar participants at Stanford University, and participants at the 2010 Western Finance Association Annual Meeting in Victoria, BC, the 2010 UBC Winter Finance Conference, and the 9th Trans-Atlantic Doctoral Confer- ence at LBS for their helpful comments. Grenadier: Graduate School of Business, Stan- ford University, 655 Knight Way, Stanford, CA, 94305, [email protected]. Malenko: MIT Sloan School of Management, 100 Main Street, E62-619, Cambridge, MA, 02142, [email protected]. 1 EEEllleeeccctttrrrooonnniiiccc cccooopppyyy aaavvvaaaiiilllaaabbbllleee aaattt::: hhhttttttppp::://////ssssssrrrnnn...cccooommm///aaabbbssstttrrraaacccttt===111333666444888333999 Abstract Westudygamesinwhichthedecisiontoexerciseanoptionisasignalofprivateinformation to outsiders, whose beliefs a⁄ect the utility of the decision maker. Signaling incentives dis- tort the timing of exercise, and the direction of distortion depends on whether the decision(cid:150) maker(cid:146)s utility increases or decreases in outsiders(cid:146)belief about the payo⁄from exercise. In the former case, signaling incentives erode the value of the option to wait and speed up option exercise, while in the latter case option exercise is delayed. We demonstrate the model(cid:146)s implications through four corporate (cid:133)nance settings: investment under managerial myopia, venture capital grandstanding, investment under cash (cid:135)ow diversion, and product market competition. 2 EEEllleeeccctttrrrooonnniiiccc cccooopppyyy aaavvvaaaiiilllaaabbbllleee aaattt::: hhhttttttppp::://////ssssssrrrnnn...cccooommm///aaabbbssstttrrraaacccttt===111333666444888333999 The real options approach to investment and other corporate (cid:133)nance decisions has be- come an increasingly important area of research in (cid:133)nancial economics. The main under- lying concept is that an investment opportunity is valuable not only because of associated cash (cid:135)ows but also because the decision to invest can be postponed. As a result, when mak- ing the investment decision, one must take into account both the direct costs of investment and the indirect costs of foregoing the option to invest in the future. The applications of the real options framework have become quite broad.1 One aspect that is typically ignored in standard models is that most real option exercise decisions are made under asymmetric information: the decision maker is better informed about the value of the option than outsiders. Given the importance of asymmetric infor- mation in corporate (cid:133)nance, it is useful to understand how it a⁄ects real option exercise decisions.2 Inthispaper, weexplorethisissuebyincorporatinginformationasymmetryinto real options modeling. We consider a setting that is (cid:135)exible enough to handle a variety of real world examples, characterize the e⁄ects of asymmetric information, and then illustrate the model using four speci(cid:133)c applications: investment under managerial myopia, venture capital grandstanding, investment under cash (cid:135)ow diversion by the manager, and product market entry decisions by two asymmetrically informed (cid:133)rms. In the presence of asymmetric information, the exercise strategy of a real option is an important information transmission mechanism. Outsiders learn information about the decision maker from observing the exercise (or lack of exercise) of the option, and thereby change their assessment of the decision maker. In turn, because the decision maker is 3 aware of this information transmission e⁄ect, the option exercise strategy is shaped to take advantage of it. To provide further motivation for the study, consider two examples of option exercise decisions, where asymmetric information and signaling are likely to be especially important. Example 1. Delegated investment decisions in corporations. In most modern corporations, the owners of the (cid:133)rm delegate investment decisions to the manager. There is substantial asymmetric information: the manager is typically much better informed about the underlying cash (cid:135)ows of the investment project than the shareholders. In this context, themanager(cid:146)s decisionwhentoinvest transmits informationabout the project(cid:146)s net present value (NPV). While in some agency settings the manager may want to signal higher project values to boost her future compensation, in other agency settings the manager may want to signal a lower project NPV to divert more value for her own private consumption. In either setting, however, the manager will take this information transmission e⁄ect into account when deciding when to invest. Example 2. Exit decisions in the venture capital industry. In the venture capital (VC) industry, there is substantial asymmetric information about the value of the fund(cid:146)s portfolio companies, since the VC (cid:133)rm that manages the fund has a much better information about the fund(cid:146)s portfolio companies than the fund(cid:146)s outside investors. In this context, the (cid:133)rm(cid:146)s decision when to sell a portfolio company transmits information about its value, and hence impacts outsiders(cid:146)inferences of the (cid:133)rm(cid:146)s investment skill. Because investorinferencesofthe(cid:133)rm(cid:146)sinvestmentskillimpactthe(cid:133)rm(cid:146)sfuturefund-raisingability, 4 the (cid:133)rm will take this information transmission e⁄ect into account when deciding when to sell a portfolio company. We call such interactions real options signaling games, and study them in detail in this paper. We begin our study with a general model of option exercise under asymmetric information. Speci(cid:133)cally, we consider a decision maker whose payo⁄ from option exer- cise is comprised of two components. The (cid:133)rst component is simply some fraction of the project(cid:146)s payo⁄. The second component, which we call the belief component, depends on outsiders(cid:146)assessment of the decision(cid:150)maker(cid:146)s type. The decision(cid:150)maker(cid:146)s type determines the project(cid:146)s NPV and is the private information of the decision maker. Our central in- terest is in separating equilibria (cid:150)equilibria in which the decision maker reveals her type through the option exercise strategy.3 We characterize a separating equilibrium of the gen- eral model, and prove that under standard regularity conditions it exists and is unique. The equilibrium is determined by a di⁄erential equation given by local incentive compatibility. We show that the implied option exercise behavior di⁄ers signi(cid:133)cantly from traditional real options models. The (cid:133)rst-best (symmetric information) exercise threshold is never an equilibrium outcome, except for the most extreme type: because the decision(cid:150)maker(cid:146)s utility depends on outsiders(cid:146)belief about the decision(cid:150)maker(cid:146)s type, there is an incentive to deviate from the symmetric information threshold to mimic a di⁄erent type and thereby take advantage of outsiders(cid:146)incorrect belief. While information asymmetry distorts the timing of option exercise, the direction of the e⁄ect is ambiguous and depends on the nature of the interactions between the decision maker and outsiders. 5 The (cid:133)rst contribution of our paper is the characterization of the direction of distortion. We show that the direction of distortion depends on a simple and intuitive characteristic: the derivative of the decision(cid:150)maker(cid:146)s payo⁄ with respect to the belief of outsiders about the decision(cid:150)maker(cid:146)s type. If the decision maker bene(cid:133)ts from outsiders believing that the project(cid:146)s value is higher than in reality, then signaling incentives lead to earlier option exercise than in the case of symmetric information. In contrast, if the decision maker bene(cid:133)ts from outsiders believing that the project(cid:146)s value is lower than in reality, then the option is exercised later than in the case of symmetric information. The intuition underlying this result comes from the fact that earlier exercise is a signal of the better quality of the project. For example, other things equal, an oil-producing (cid:133)rm decides to drill an oil well at a lower oil price threshold when it believes that the quality of the oil well is higher. Because of this, if the decision maker bene(cid:133)ts from outsiders believing that the project(cid:146)s quality is higher (lower) than in reality, she has incentives to deviate from the (cid:133)rst-best exercise threshold by exercising the option marginally earlier (later) and attempting to fool the market into believing that the project(cid:146)s quality is higher (lower) than in reality. In equilibrium, the exercise threshold will be lowered (raised) to the point at which the decision(cid:150)maker(cid:146)s marginal costs of ine¢ ciently early (late) exercise exactly o⁄set her marginal bene(cid:133)ts from fooling outsiders. Importantly, outsiders are rational. They are aware that the decision maker shapes the exercise strategy to a⁄ect their belief. As a result, in equilibrium outsiders always correctly infer the private information of the agent. However, even though the private information is always revealed in equilibrium, 6 signal-jamming occurs: the exercise thresholds of all types, except for the most extreme type, are di⁄erent from the (cid:133)rst-best case and are such that no type has an incentive to fool outsiders. The second contribution of our paper is illustrating the general model with four cor- porate (cid:133)nance applications that put additional structure on the belief component of the decision(cid:150)maker(cid:146)s payo⁄: investment under managerial myopia, venture capital grandstand- ing, investment under cash (cid:135)ow diversion by the manager, and product market entry deci- sions by two asymmetrically informed (cid:133)rms. The (cid:133)rst application we consider is a timing analog to the myopia model of Stein (1989). We consider a public corporation, in which the investment decision is delegated to a manager, who has superior information about the project(cid:146)s NPV. As in Stein (1989), the manager is myopic in that she cares not only about the long-term performance of the company but also about the short-term stock price. The timing of investment reveals the manager(cid:146)s private information about the project and thereby a⁄ects the stock price. As a result, the manager invests ine¢ ciently by exercising her investment option too early in an attempt to fool the market into overestimating the project(cid:146)s NPV and thereby in(cid:135)ating the current stock price. The second application deals with the VC industry. As discussed in Gompers (1996), younger VC (cid:133)rms often take companies public earlier than older VC (cid:133)rms to establish a reputation and successfully raise capital for new funds. Gompers terms this phenomenon (cid:147)grandstanding(cid:148)and suggests that inexperienced VC (cid:133)rms employ early timing of initial public o⁄erings (IPOs) as a signal of their ability to form higher-quality portfolios. We 7 formalize this idea in a two-stage model of VC investment. An inexperienced VC (cid:133)rm investslimitedpartners(cid:146)moneyinthe(cid:133)rstroundandthendecideswhentotakeitsportfolio companypublic. Limitedpartnersupdatetheirestimateofthegeneralpartner(cid:146)sinvestment- picking ability by observing when the decision to take the portfolio company public is made and use this estimate when deciding how much to invest in the second round. Because the amount of second round (cid:133)nancing is positively related to the limited partners(cid:146)estimate of thegeneralpartner(cid:146)sability, thegeneralpartnerhasanincentivetofoolthelimitedpartners into believing that her ability is higher. Since an earlier IPO is a signal of better quality of the inexperienced general partner, signaling incentives lead to earlier than optimal exit timing of inexperienced general partners, consistent with the grandstanding phenomenon of Gompers (1996). The other two applications belong to the case of the decision maker bene(cid:133)ting more when outsiders believe that the project(cid:146)s NPV is lower than in reality, and thus imply an ine¢ ciently delayed option exercise. Similar to the (cid:133)rst application, the third application studies a delegated investment decision in a corporation. However, unlike the second appli- cation, the nature of the agency con(cid:135)ict is di⁄erent. Speci(cid:133)cally, we consider a setting in which a manager can divert a portion of the project(cid:146)s cash (cid:135)ows for private consumption, which makes the problem a timing analogue of the literature on agency, asymmetric infor- mation, and capital budgeting (e.g., Harris, Kriebel, and Raviv 1982; Stulz 1990; Bernardo, Cai, and Luo 2001). In this application, private information gives the manager an incentive to delay investment so that outside investors underestimate the true NPV of the project, 8 which allows the manager to divert more without being caught. This creates incentives to fool outside investors by investing as if the project was worse than in reality and thereby leads to later investment than in the case of symmetric information. In equilibrium outside investorscorrectlyinfertheNPVoftheproject, butstillsignal-jammingoccurs: investment is ine¢ ciently delayed to prevent the manager from fooling outside investors. Finally, the fourth application we consider is sequential entry into a product market in the duopoly framework outlined in Chapter 9 of Dixit and Pindyck (1994). The major distinction of our application is that we relax the assumption that both (cid:133)rms observe the potential NPV from launching the new product. Instead, we assume that the two (cid:133)rms are asymmetrically informed: one (cid:133)rm knows the project(cid:146)s NPV, while the other learns it from observing the investment (or lack of investment) of the better informed (cid:133)rm. As a result, the better informed (cid:133)rm has an incentive to delay investment to signal that the quality of the project is worse than in reality and thereby delay the entry of its competitor and enjoy monopoly power for a longer period of time. Thus, the timing of investment is ine¢ ciently delayed. However, the under-informed (cid:133)rm rationally anticipates the delay of investment by the better informed (cid:133)rm, so in equilibrium the timing of investment reveals the NPV of the product truthfully. Our (cid:133)ndings have a number of implications. First, the e⁄ect of information asymmetry on investment timing is far from straightforward. In fact, information asymmetry can both speed up and delay investment, thus leading to overinvestment and underinvestment, re- spectively. The direction of distortion depends on the nature of the agency con(cid:135)ict between 9

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Andrey Malenko. Massachusetts Institute of Technology. June 2011. *We thank the anonymous referee, Anat Admati, Felipe Aguerrevere, Geert
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